Brexit Insight 06 Jul 2016 ​Brexit: The Impact on Derivatives Regulation

Following the referendum on 23 June 2016, the UK’s impending departure from the EU raises immediate issues for participants in the derivatives markets. OTC derivatives business has been the subject of much of the barrage of new regulation affecting financial services in Europe and worldwide in recent years, and the impact of the UK leaving the EU will be substantial.

For example, the operational complexity of the introduction of the new margin rules is compounded by uncertainty as to the future status of UK banks and investment firms trading with their peers in EU Member States.

The new powers of national supervisors to resolve failing banks are only just becoming familiar to practitioners, and detaching the UK from the framework legislation will have consequences for cross-border recognition of resolution and potential impact on enforcement of security. Furthermore, with the future legal relationship between the UK and the EU yet to be resolved, the availability of third- country “equivalence” provisions across the suite of EU financial services regulations may be a critical factor in the ability of UK firms to trade with European counterparties. The availability of such equivalence provisions is at best incomplete, and decisions on equivalence are required to be made under the specific provision rather than wholesale for a given Directive or Regulation. We explain this in more detail below. This briefing builds on our previous publications on the implications of Brexit for the banking industry, which we published prior to and immediately following the referendum. Those publications are available here and here. This briefing concentrates on implications specific to the derivatives market, and delves more deeply into some of the issues explained in those publications.

Terms appearing in bold are explained in the Glossary.

Scope of the single market – the EEA

Any examination of the implications of Brexit for EU financial services legislation involves understanding the current scope of Directives and Regulations enacted by the EU bodies, and whether they apply across the EEA or just within the EU. The EEA consists of the EU Member States and three additional countries which are signatories to the EEA Agreement, being Iceland, Liechtenstein and Norway (the fourth EFTA country, Switzerland, is not a member of the EEA).

The EEA Agreement is the framework agreement by which these three countries are able to participate in the EU’s internal market. However an individual piece of EU legislation will only apply across the EEA if it is incorporated into the EEA Agreement (whether or not the legislation is marked as a “Text with EEA relevance”, which often appears at the top of the published version). In this briefing we indicate whether each relevant piece of legislation has been incorporated into the EEA Agreement. This is relevant because one possible outcome for the UK would be to remain in the EEA, in which case it would continue to have access to the single market. Outside the EEA, equivalence decisions become critical in order to maintain that access as explained overleaf.

Derivatives and the single market - passporting and equivalence

These two terms are currently ubiquitous, and it is worth spending a minute looking at what they mean before considering the problems and gaps inherent in any post-Brexit model.

Authorisation and Passporting of investment services in derivatives

In brief, MiFID requires that any EU person conducting an investment service or activity on a professional basis in respect of financial instruments must be authorised by the competent authority in its home member state. Investment activities include, among other things, dealing on own account or executing transactions as an agent for clients, including in derivative instruments (although for MiFID purposes “derivatives” do not include repo transactions). “Dealing on own account” is interpreted widely, and includes any transaction where a firm trades against proprietary capital, whether hedging or otherwise, subject to certain exceptions. Commentary on the meaning of these expressions and the exemptions is extensive, but in summary it is unlikely that trading operations by professional firms established in the EU could be carried on without authorisation from the relevant competent authority (such as the FCA in the case of the UK).

An EU bank or investment firm so authorised in its home member state is permitted to provide these services in member states across the EU without further authorisation being required in the host member state. This is the result of the MiFID “passport”. As MiFID has been incorporated into the EEA Agreement the MiFID passport is also available to firms established in the Additional EEA Member States, i.e. Iceland, Norway and Liechtenstein.

Meanwhile, non-EEA firms cannot benefit from the MiFID passport, even though authorised by their national supervisor. As a result, for example, US, Swiss, Japanese and Australian banks wishing to provide investment services in relation to derivatives using the passport are required to establish a subsidiary authorised in an EEA Member State. This is due to change to some extent when MiFID II comes into force in January 2018, and an “equivalence” provision (see below) becomes available, allowing firms in third countries which have been deemed equivalent for MiFID purposes by the European Commission, and provided the firm is registered with ESMA, to deal with professional and eligible counterparties across the EU. However this extension of MiFID II to firms in equivalent third countries is not available in respect of investment services provided to retail clients without establishment of a branch in the relevant EEA Member State.

Furthermore, a non-EEA branch of a bank or investment firm authorised in another EU Member State cannot rely on the passport “owned” by the EU entity to conduct investment business from outside the EEA into Europe. This means that if the UK does not join the EEA, UK branches currently using the passport of an EU head office and wishing to continue conducting investment activities with professional clients across the EU will need (i) to become established in the UK, (ii) to obtain their own UK authorisation, and (iii) then rely on the UK obtaining equivalence under MiFID II. Alternatively, the relevant activities would have to be transferred to an affiliate which is an EEA firm, in order to benefit from the passport.

It should be noted that the above applies to the provision of investment services across the single market. It remains possible for individual EEA Member States to allow firms established in third countries to provide investment services within their own jurisdiction, subject to their own local law. Theoretically therefore, a UK firm may be able to provide investment services in individual EEA Member States on a piecemeal basis. However this approach is fraught with complexity, due to lack of clarity around where exactly an investment service is deemed to take place – an issue which is less significant when using the passport. 

In addition, this would mean that the UK firm would need to comply with the requirements and exceptions in multiple Member States which differ across the other 27 EU Member States and the three Additional EEA Member States. This would clearly make it more complex and costly to carry on these activities from the UK. 

A similar passport is also available for deposit-taking institutions under the Capital Requirements Directive. However, there are no equivalence provisions which would enable UK banks to continue to passport their services into the EU following the departure of the UK.

Equivalence

An “equivalence” provision in EU financial services legislation is, broadly, a provision under which institutions based in third countries with legal and regulatory requirements equivalent to those set out in the EU regulation, can effectively deal with EU counterparties on the same terms as can their EU peers.

Equivalence decisions by the Commission are provided for in many areas of financial regulation which affect derivatives trading between regulated counterparties, as well as between regulated counterparties and corporates. For instance, central counterparties authorised by a supervisor in equivalent third countries can provide clearing services recognised under the mandatory clearing provisions under EMIR. Derivatives counterparties based in equivalent third countries can comply with the equivalent country’s rules rather than those in EMIR, and can obtain exemptions from margining altogether when trading intragroup with EU counterparties. We discuss certain equivalence provisions in the context of specific regulations below.

The availability of equivalence provisions, and the likelihood of the Commission making an equivalence decision in respect of UK regulatory provisions if the UK does not remain a member of the EEA, could be crucial to the smooth continuation of the UK cross-border derivatives market. However this will depend on the post-Brexit model agreed by the UK and the remaining EU Member States, as discussed further below.

Even if equivalence decisions are made by the Commission in respect of UK rules, this may not mean that UK rules will automatically be treated as equivalent to their EU counterparts by non-EU regulators. For example, rules governing the authorisation of CCPs under EMIR are treated as equivalent by the Commodity Futures Trading Commission for the purpose of the US clearing regime, meaning that firms within scope of the US clearing rules can clear trades through an EU-based CCP. If the UK leaves the EEA, it is possible that separate bilateral negotiations will be required with non-EU regulators to ensure that UK rules are treated as equivalent even where an equivalence decision has been made by the Commission. Those negotiations may not be able to take place until the UK’s post-Brexit model is known.

The UK’s withdrawal from the EU will, absent agreement to the contrary, need to follow the process set out in Article 50 of the Treaty on European Union and will take effect on the earlier of:

• entry into force of a withdrawal agreement establishing the framework of the UK’s future relationship with the EU; and
• two years after the UK government gives notice of withdrawal to the European Council (in the absence of unanimous agreement to extend).

At that stage, the EC Act, by which the UK joined the EU as a matter of domestic law, would need to be repealed. Of itself however, the repeal of the EC Act does not end the UK’s relationship with EU financial services legislation. Whether EU law or regulation continues to apply within the UK following repeal of the EC Act depends on whether the relevant EU provision is enacted in the form of a Regulation such as EMIR (and any supplemental delegated regulations) which takes effect in Member States without implementing legislation at the national level, or a Directive such as MiFID (and any supplemental delegated regulations) which is required to be implemented into the national law of each Member State. Some of MiFID was implemented in the UK through FSMA and secondary legislation made under enabling provisions in FSMA. Those provisions of FSMA therefore form part of UK law and will remain so after Brexit, unless specifically repealed or amended. However some of MiFID II is implemented in the UK through statutory instrument made under the EC Act, and saving legislation would be needed to preserve it after Brexit.

Conversely, following repeal of the EC Act, rules such as EMIR, which take direct effect in the EU and do not have implementing UK provisions, will cease to be part of UK law. If the UK wishes to preserve the status quo – and arguably the highest chance of a swift equivalence decision from the Commission – “saving legislation” will be required to be enacted in key areas. 

Exit provisions under Article 50 of the Treaty on European Union

Possible post-departure models and treatment of UK banks

Our previous briefings discuss the possible post-Brexit models for the relationship between the UK and the EU. It is too early to say which of the possible models will emerge, but if the UK does not remain as an EEA member, any model based on a free trade agreement (such as Canada), or a set of bilateral agreements (such as Switzerland, less likely in our view), is likely to be dependent on a number of crucial equivalence decisions if UK firms are to continue to trade on equal terms with their EEA counterparties. At the other end of the spectrum is the “most-favoured nation” model required by the World Trade Organization, which would mean that the UK would not have automatic access to the internal market of the EU. With this in mind, the distinction we make in this briefing for the purpose of derivatives regulation is between (i) the UK being a member of the EEA, and (ii) the UK being a third country outside the EEA, where the obtaining of equivalence decisions will be key.

Remember however that until 2018, when MiFID II comes into force, no equivalence determination is available to allow UK firms to benefit from the passporting of investment services under MiFID.

In theory, the UK should easily meet many equivalence requirements across the suite of financial services regulation (including those for use of the MiFID II passport), as it has been operating within these rules to date and has implemented EU rules into UK law where required. Where saving legislation needs to be enacted, the likelihood is that it will be enacted with minimal change in many areas. However in practice the application process is likely to be a political and time consuming one and is by no means certain. In general, equivalence is ultimately determined at the discretion of the European Commission, and any determination will depend not only on the content of the equivalent rules themselves but on their legal and supervisory context. As a result there is no guarantee that even identical rules will be treated as equivalent, particularly in a difficult political climate.

Specific EU regulations affecting derivatives – EEA membership versus equivalence 

EMIR

What does EMIR do?

EMIR requires the mandatory clearing of certain classes of OTC derivative transactions through authorised central counterparties.These clearing requirements apply to most regulated counterparties, as well as to the larger corporate participants in the derivatives market. EMIR also requires certain risk mitigation procedures to be followed by counterparties to non-cleared OTC derivatives, including compliance with detailed rules governing the collection/exchange of both initial and variation margin. The requirements of EMIR also affect counterparties outside the EEA in certain circumstance

Has EMIR been incorporated into the EEA Agreement?

Almost. EMIR is a Text with EEA relevance and has recently completed the scrutiny process for incorporation into the EEA Agreement. We assume that incorporation will happen in the short-term future.

Direct or indirect?

EMIR and the delegated acts made under it are directly applicable in all EEA Member States so it will no longer apply if the UK
does not remain in the EEA, unless the UK adopts legislation preserving the status quo.

Margining

Is there an international accord behind EMIR margining rules?

Yes. The EMIR margining requirements aim to implement the BCBS and IOSCO margin requirements for non-centrally-cleared derivatives, published in March 2015

Position for UK banks and investment firms if the UK is within the EEA

If the UK joins the EEA, margining obligations which apply to UK-based derivatives counterparties under EMIR will continue to apply.

Position for UK banks and investment firms if the UK is a third country 

Uncertain. However, as the UK is a G20 and BCBS member, it is likely to adhere to rules implementing the BCBS/IOSCO requirements even if it leaves the EEA, so is likely to adopt the EMIR margining requirements wholesale in order to achieve this.

Equivalence decisions are available in respect of margining requirements under Article 13 of EMIR. Article 13 provides that the EU Commission may adopt implementing acts declaring that the legal, supervisory and enforcement arrangements of a third country are equivalent to the requirements laid down in the EMIR margining requirements and are being effectively applied and enforced so as to ensure effective supervision and enforcement in that third country. If the UK adopts the EMIR margining requirements without amendment, an equivalence decision is clearly more likely.

Where such an equivalence decision is made, counterparties to derivatives transactions will be deemed to have fulfilled the EMIR margin requirements where at least one of the counterparties is established in that equivalent third country. This means that compliance with only one set of rules would be required (i.e. the EMIR margin rules or the UK’s equivalent margin rules).

Position with respect to trading with EEA entities

Whether the UK joins the EEA or is a third country, EMIR will still apply to any EEA-based counterparty of a UK entity.

This is because EMIR requires that margin is collected by in-scope EEA entities regardless of the place of establishment of the counterparty to the trade. If the UK is a third country then, in the absence of an equivalence decision in respect of the UK margin requirements, any trade between a UK entity and an EEA entity will still require the EEA entity to collect margin in compliance with the margining requirements under EMIR, and furthermore that margin must be exchanged with (as opposed to just collected from) non-EEA entities who would be subject to the requirements if they were established in the EEA. Thus UK entities which are currently within scope of EMIR (financial counterparties or NFC+s) would still need to comply with the EMIR margin rules when transacting with an EEA counterparty, even if the UK is outside the EEA. These requirements are subject to the exemptions and opt-outs in EMIR itself, and the delegated acts made under Article 11 – for which, see our March 2016 briefing.

The ESAs’ final draft of the margin rules also extended the scope of contracts caught by the rules to contracts which do not fall within the EMIR definition of OTC derivatives.

As a result, where a counterparty is domiciled in a third country using a definition of OTC derivative contracts that is different from that used in EMIR, counterparties must calculate margin for all contracts that fall within either the EMIR definition of OTC derivative contract or the definition used in the third country provided that the counterparty domiciled in the third country is subject to margin requirements. Effectively this means that, even if the UK is outside the EEA, any change made by new UK legislation to the scope of the margin requirements will not be able to avoid the application of the EMIR requirements to derivatives caught by the EMIR margin rules.

No equivalence decisions have yet been issued in respect of the margin requirements under EMIR. Any equivalence decision in respect of margin requirements in the UK will first require the UK to enact equivalent rules, and the Commission to make the determination under Article 13. This could take some time.

Position with respect to intragroup transactions

There are certain exemptions from the clearing and margining requirements of EMIR for transactions made intragroup, but these depend upon the parties being either in EEA Member States or in third countries in respect of which equivalence decisions have been made by the Commission. In the absence of equivalence decisions, UK entities entering into derivative transactions with group members in the EEA may be required to clear and margin their trades as though they were unconnected entities. This can arise where a bank group uses one entity to enter into customer-facing transactions, and then enters into a back-to-back transaction with a group affiliate to manage its risk.

Position if there is no equivalence, or the UK does not implement margin rules

If the UK does not implement the EMIR margin rules, or if the UK does not obtain an equivalence decision from the Commission, it is possible that UK-based firms entering derivatives contracts with their EEA counterparts will have to ensure that margining of those contracts complies with two sets of regulations – those made under EMIR, and those applicable in the UK. It is therefore in the interests of the UK derivatives industry that margin rules are implemented which replicate as closely as possible those made under EMIR, regardless of whether an equivalence decision is forthcoming.

The exact timing for implementation of the EMIR margin rules is currently unclear due to a delay in adoption of the rules by the European Commission. We understand that as a result the first initial and variation requirements are likely to apply from early to
mid-2017.

What do firms need to do now?

As the process of the UK leaving the EU is expected to take at least two years from the date on which the UK invokes Article 50 of the Treaty on European Union, the requirements to implement the EMIR margin rules will commence whilst the UK is still an EU Member State. Also, as the likely options post-Brexit all involve the UK either preserving the EMIR margin rules or adopting rules for which it intends to seek an equivalence decision, firms should continue to prepare for phase-in of the EMIR margin rules in accordance with the expected timeline. 

Mandatory Clearing

Is there an international accord behind EMIR mandatory clearing rules? 

Yes. The EMIR clearing requirements are aimed at implementation of the G20 commitments on OTC derivatives agreed in Pittsburgh in September 2009 and reflected in the “Requirements for Mandatory Clearing” published by IOSCO in February 2012 as part of its “Principles for Financial Markets Infrastructure”.

Position for UK banks and investment firms if the UK is within the EEA

If the UK joins the EEA, clearing obligations which apply to UK-based derivatives counterparties under EMIR will continue to apply.

Position for UK banks and investment firms if the UK is a third country

Uncertain. However, as the UK is a G20 member, it is likely to implement the IOSCO mandatory clearing requirements even if it leaves the EEA, so could adopt the EMIR margining requirements wholesale in order to achieve this. Equivalence decisions are available in respect of clearing requirements under Article 13 of EMIR. Article 13 provides that the EU Commission may adopt implementing acts declaring that the legal, supervisory and enforcement arrangements of a third country are equivalent to the EMIR clearing requirements and are being effectively applied and enforced so as to ensure effective supervision and enforcement in that third country. Where such an equivalence decision is made, counterparties to derivatives transactions will be deemed to have fulfilled the clearing requirements where at least one of the counterparties is established in that equivalent third country.

Position with respect to trading with EU entities

Mandatory clearing under EMIR applies to trades entered between FCs or NFC+s and counterparties in third countries where those third-country counterparties would have been subject to the clearing obligation if they were established in the EEA. In practice therefore, where the UK does not remain in the EEA and whether or not there is an equivalence decision, UK entities trading with EEA counterparties will still be subject to mandatory clearing under EMIR if the UK entity would have been an FC or NFC+ if the UK had remained part of the EEA.

What do firms need to do now?

Firms do not need to take any action immediately. The EMIR clearing requirements will continue to apply during the process of negotiation to leave the EU and transactions should be cleared as and when the clearing obligation takes effect for new classes of derivative.

CCP recognition

Is there an international accord behind EMIR CCP authorisation requirements?

Yes. The EMIR requirements for CCP authorisation are aimed at implementation of the “Principles for Financial Markets Infrastructure” published by IOSCO in February 2012.Position for UK CCPs if the UK is within the EEA If the UK joins the EEA, UK-based CCPs will continue to be able to seek authorisation under EMIR in the same way as they would be if established in the EU.

Position for UK CCPs if the UK is a third country

Article 25 of EMIR provides for equivalence decisions to be made by the Commission in respect of third-country CCPs where CCPs authorised in the third country comply with applicable prudential requirements for CCPs in the third country, and the third country has legally binding requirements for supervision of CCPs which are equivalent to those in EMIR. Again the UK should be able to comply with these requirements, but will still need a declaration of equivalence under Article 25 to be made by the EU Commission. There have so far been several equivalence decisions in respect of third countries, but obtaining such a decision for the UK may still take some time.

If an equivalence decision is made, a CCP in the relevant third country can apply to ESMA for recognition under EMIR. 

ESMA may recognise the CCP if the third country also meets certain anti-money laundering criteria, and the third country has entered agreements for cooperation between the third-country supervisors and ESMA.

Position with respect to providing clearing services to EEA entities

The so-called “bottom-up” approach to clearing being rolled out under EMIR – by which new classes of derivative are brought within the clearing obligation as and when CCPs are authorised under EMIR – will still bring within scope derivative contracts cleared by UK CCPs, provided that there is an equivalence decision in respect of UK supervision of CCPs. If an equivalence decision is made, and following it a UK CCP is recognised under Article 25, ESMA is then required under Article 5 of EMIR to draft regulatory technical standards specifying the classes of derivative cleared by that CCP that should be subject to the clearing obligation, in much the same way as it would do following notification of authorisation of an EEA-based CCP. The UK CCP would then be eligible to clear trades for the purpose of EMIR compliance.

In the absence of equivalence however, classes of derivative cleared by UK CCPs will not become subject to mandatory clearing under EMIR, until they are cleared by another EEA-authorised CCP.

The referendum result has also prompted renewed calls for clearing houses handling euro- denominated products to be based in the Eurozone. The ECB has in the past made a similar proposal which was the subject of a ruling of the EU General Court in March 2015. At that time the Court found in favour of the UK, saying that that the ECB did not have the “competence necessary to regulate the activity of security clearing systems”. However, now that the UK will no longer be an EU Member State, calls are again being made to challenge the ability of UK-based clearing houses to clear euro-denominated derivatives trades. This could potentially force UK clearing houses to establish – or use existing – entities within the Eurozone in order to offer clearing services in these products.

Clearing members of EEA CCPs

Where EEA CCPs’ eligibility criteria require clearing members to be EU-authorised credit institutions or investment firms it may be that, if the UK does not join the EEA, provision would have to be made to allow UK firms to remain as clearing members.

Bank Recovery and Resolution Directive

What does BRRD do?

BRRD aims to provide more robust tools for dealing with insolvent or failing banks and investment firms as well as a framework for cooperation in cross-border resolution action. In particular, BRRD introduces the concept of “bail-in”, which allows bank supervisors to write down or convert to equity the liabilities of a bank rather than relying on the taxpayer to provide a “bailout”. The approach of BRRD is that Member State regulators have jurisdiction to take resolution action in relation to financial institutions for which they are the home state regulator. Given that an international financial institution may have subsidiaries, branches and/or assets located in a state outside its home state and rights and/or liabilities governed by the law of a state other than its home state, it is necessary to consider whether resolution action taken in one state will be recognised in another.

Has BRRD been incorporated into the EEA Agreement?

Not yet. BRRD is a Text with EEA relevance and is currently under scrutiny by the EFTA Member States for adoption into the EEA Agreement.

Direct or indirect?

BRRD does not have direct effect in EU Member States and was required to be implemented into the national law of EU Member States including UK law. In the UK this was done through amendments to the Banking Act 2009, which were largely made through statutory instrument under section 2(2) of the EC Act as well as amendments to the PRA and FCA rules made under FSMA. To the extent the amendments were made by statutory instrument under section 2(2) of the EC Act, saving legislation will be needed to preserve them after Brexit.

Is there an international accord governing bank resolution?

Yes, the FSB published a document entitled “Key Attributes of Effective Resolution Regimes for Financial Institutions” in November 2011 (and this was expanded in October 2014). BRRD seeks to implement the principles set out in that document and aims to give national regulators credible resolution powers and tools for dealing with unsound or failing financial institutions, including the power of bail-in.

In November 2015, the FSB published a document entitled “Principles for Cross-Border Effectiveness of Resolution Actions”, in which it called for its member jurisdictions to create legal mechanisms for cross-border recognition of resolution action and set out proposals for statutory and contractual approaches to such mechanisms. A comprehensive international system of crossborder recognition is some way from being achieved, although BRRD provides a recognition framework within the EEA.

If the UK leaves the EU then there will be a risk of cross-border recognition of resolution measures being weakened or disrupted, making it more difficult to resolve failing banks effectively. We now consider the position if the UK either is within the EEA or is a third country.

Position for UK banks and investment firms if the UK is within the EEA

If the UK joins the EEA, resolution action in respect of UK banks and investment firms which are subject to prudential supervision will be recognised by the other EEA Member States as a result of the recognition provision in Article 3 of CIWUD. CIWUD was incorporated into the EEA Agreement in 2003 and therefore also applies to all of the EEA Member States. It was amended by Article 117 of BRRD with the effect that the recognition provision extends to recognition of resolution action taken by EEA Member States in accordance with BRRD.

The UK implemented CIWUD by means of CIWUR, and has included BRRD resolution tools as reorganisation measures which are recognised by the UK. Unless this is amended, the UK will continue to recognise resolution action taken by other EU member states (and by all EEA Member States once BRRD is incorporated into the EEA Agreement). If the UK remains in the EEA, these reciprocal arrangements mean that resolution action taken in respect of UK banks and investment firms by the UK authorities will be recognised across the EEA.

This means that, for example, the use of the bail-in tool in respect of the liabilities of a failing bank, or the power of sale of the bank’s UK assets by a resolution authority in another EEA Member State would be recognised by the UK courts, and vice versa. This should therefore bind parties to an ISDA master agreement which is governed by English law, as the English courts should recognise powers exercised by an EEA regulator under BRRD. Conversely, parties to any master agreements governed by the law of an EEA Member State, such as French law FBFs or German law Rahmenvertrag, should be bound by resolution measures taken by a UK resolution authority in accordance with BRRD.

Furthermore, the requirements of Article 55 of BRRD will continue to apply in the same way as they have done to date if the UK joins the EEA.

Article 55 requires that contracts governed by the law of a non-EEA country, giving rise to liabilities of an EEA bank or investment firm subject to BRRD, or by certain group holding companies of such firms, must include contractual recognition of the use of the bail-in tool in respect of the liability of the EEA institution, unless the liability is excluded from bail-in.

The provisions as to valuation of derivatives in the event of a bail-in under Article 49 of BRRD and the delegated acts supplementing it, which were adopted by the Commission on 23 May 2016, will also continue to apply in the UK if the UK joins the EEA. See our May 2016 briefing on this for further detail.

Position for UK banks and investment firms if the UK is a third country

Uncertain. However, in the light of the FSB’s calls for an international recognition framework, it is likely that the UK will retain its implementing legislation in respect of BRRD, particularly as in some areas it pre-dated the equivalent BRRD provision or is broader
in scope than the equivalent BRRD provision. As BRRD has been implemented into UK law, the resolution tools, including the bail-in tool, will continue to apply to UK banks and investment firms post-Brexit unless these provisions are specifically repealed. Such a repeal is highly unlikely as the UK took a lead in implementing bank resolution legislation, including bail-in. Also, the PRA has to some degree broadened the scope of BRRD in relation to the liabilities in respect of which a contractual recognition of the bail-in tool is required and has implemented a rule on contractual recognition of the BRRD resolution stays, which is not required by BRRD itself (for further detail, see our November 2015 briefing). Some amendment to the resolution tools would nevertheless be possible as the UK would no longer be bound by BRRD.

With respect to bail-in, in the Banking Act the UK has implemented protections from bail-in for derivatives contracts (including for this purpose repo and stocklending) made under a master netting agreement, to the extent that the netting has not taken effect. The order for bail-in may take effect to convert the outstanding liabilities under the master agreement into the net liability, but only the net amount will be subject to the write-down power. This is similar in effect to the provisions of the EU regulatory technical standards made under Article 49 of BRRD, adopted by the EU Commission in May 2016. The UK was ahead of the EU in implementing these provisions protecting netting agreements in a bail-in, and it is almost inconceivable that UK law would remove the protection of netting agreements in these circumstances.

However, whilst recognition of other EEA Member States’ use of the resolution tools has already been implemented into UK law, it is unclear whether reciprocal recognition arrangements can be negotiated with remaining EU Member States to apply between the UK and the EEA.

Such recognition is important for enforcement of netting and security rights. For instance, although financial collateral arrangements are protected under the FCA Regs in the event of a winding-up of the collateral provider or collateral taker, these protections are overridden in certain respects in the event of resolution action being taken in respect of a bank or investment firm. As a result, the financial collateral protections do not prevent the Bank of England from imposing the resolution stays on close-out netting and enforcement of security contained in Sections 70B and C of the Banking Act 2009. There is no reason that the UK would change these provisions, but if the UK is not a member of the EEA, resolution stays imposed under UK law may not be recognised under the law of EU Member states. This means, for example, that if a collateral taker holds securities posted by a UK bank in a clearing system subject to a Belgian-law security interest, the collateral-taker may still be able to enforce that security interest under Belgian law even though the UK bank is subject to a resolution stay under UK law. In addition, rights to terminate derivatives transactions under French or German law master agreements may become exercisable against a failing UK bank notwithstanding the imposition of a resolution stay. 

Article 93 of BRRD contemplates that the European Commission may produce proposals for contingency agreements with nonEEA states governing cooperation between resolution authorities in the event of resolution of third-country banks which have branches, subsidiaries or parent undertakings in EEA Member States and vice versa.

Pending such agreements, Article 94 provides general mechanisms for recognition by EEA Member States of third-country resolution measures. These include joint recognition decision by a resolution college, if there is one, or, if there is no resolution college (or it does not reach a decision), each EEA Member State’s resolution authority can make its own decision. Each such decision must take into account the interests and financial stability of the EEA Member State where the third-country institution operates. Such decisions are also subject to detailed public interest and public policy exclusions under Article 95, which may perhaps reduce the likelihood of a recognition decision being made in respect of UK resolution action in respect of a UK bank. 

If no such cooperation agreement or recognition decision were made, a concern would be that courts in other Member States may not recognise the effect of resolution measures taken by a UK regulator.

This could hamper UK regulators’ ability to bail-in or modify liabilities governed by an EU law, such as under French or German law agreements. UK law would therefore need to require at least the contractual recognition of bail-in clauses to be included in agreements governed by the law of an EEA Member State, to ensure that such contracts could be bailed in.

Conversely, if the UK does not join the EEA, UK law would also cease to be the law of an EEA Member State and as a result, contractual recognition of bail-in would need to be included in English law governed contracts with EEA banks and investment firms under Article 55 of BRRD.

What do firms need to do now?

Firms should carry on implementing the contractual recognition requirements in respect of bail-in and (for UK firms) resolution stays in the same way as they have done to date. When it becomes clear whether or not the UK will join the EEA, it will be necessary to revisit these issues to determine whether UK law governed contracts may need to include contractual recognition of bail-in of the liabilities of an EU bank or investment firm, and vice versa.

Financial Collateral Directive

What does the FCD do?

The FCD requires that EEA Member States disapply certain formalities and provisions of insolvency law in relation to title transfer or security financial collateral arrangements, provided that the collateral taker has control of the collateral, and provides collateraltakers with an immediate right of sale or appropriation and a right of set-off, rights of re-use of collateral, protection of close-out netting provisions and protection from insolvency moratoria

Has the FCD been incorporated into the EEA Agreement?

Yes. The FCD is incorporated into the EEA agreement and is in force throughout the EEA.

Direct or Indirect?

The FCD does not take direct effect in EU Member States and was required to be implemented into UK law. This was done by means of a statutory instrument which, following repeal and re-enactment, is currently the FCA Regs. The FCA Regs were, however, made directly under an enabling provision in the EC Act itself, rather than under FSMA or the Banking Act 2009 as would be the case with much financial services legislation. As a result, repeal of the EC Act at the date the UK leaves the EU will automatically repeal the FCA Regs, which would need to be re-enacted as primary UK legislation if the protections for creditors contained in them are to be preserved.

Position for UK banks and investment firms if the UK is within the EEA

As the FCD has been incorporated into the EEA Agreement, if the UK joins the EEA it will be required to implement legislation preserving the effect of the FCA Regs when they fall away as a result of the repeal of the EC Act. Thus financial collateral arrangements entered by UK firms will continue to be recognised across the EEA Member States.

Position for UK banks and investment firms if the UK is a third country

There is no requirement in FCD itself that either the collateral taker or collateral provider is established in the EEA, although naturally a financial collateral arrangement will be relied upon when the collateral provider is subject to an insolvency proceeding governed by the law of an EEA Member State, so is therefore likely to be an EEA entity.

If the UK does not join the EEA and does not retain the FCA Regs, whether a UK bank holding collateral and relying on a financial collateral arrangement is still able to appropriate the collateral and close out transactions with the usual protections provided for financial collateral arrangements notwithstanding the commencement of winding-up proceedings, will depend in part on the governing law of the security interest. Absent the FCA Regs, the status of powers of appropriation in English law security interests will be unclear given that this is not a remedy familiar to English common law or statute, the closest equivalent being foreclosure, which requires a court order.

Under the FCD, only one of the collateral provider and the collateral taker needs to be a financial entity such as a bank or investment firm, central counterparty, or a public body or central bank. The other party may be any non-natural person. However, individual EEA Member States are permitted to require, in their implementing legislation, that both parties are institutions in the former list (the “restrictive option”), and arrangements where one party is any other non-natural person (e.g. a corporate) will therefore not fall within the arrangements protected by the FCD. The effect of this is that a non-financial corporate entity will only be able to rely on a financial collateral arrangement with an entity in another EEA Member State if that other EEA Member State has not implemented FCD using the restrictive option. However, it is irrelevant that the collateral taker in this instance is outside the EEA – what prevents reliance on the financial collateral arrangement is the fact that the collateral taker is not a financial entity. Thus where a UK financial institution seeks to rely on an FCA, it shall not matter whether the UK is an EEA Member State or is fully outside the EEA

The UK implemented FCD more broadly than FCD itself provides, allowing arrangements to qualify as financial collateral arrangements where the parties are both non-natural persons. This means that assuming the UK does preserve the FCA Regs through saving legislation, collateral takers in other EEA Member States will still be able to rely on financial collateral arrangements in respect of collateral provided by UK entities, regardless of whether the UK joins the EEA or not. 

If the UK were to fail to implement preserving legislation however, the question arises as to whether any security interests which, absent the FCA Regs would have been required to be registered under the Companies Acts and have relied on the disapplication of formal registration requirements, will be valid. Under section 859H of the Companies Act 2006 (and predecessor provisions), a registrable charge is void against the liquidator of a company in the UK. In our view saving legislation would be likely to be enacted to preserve pre-existing security interests which rely on the FCA Regs, and as such it is unlikely that the validity of security interests which currently qualify as security financial collateral arrangements will be jeopardised.

What do firms need to do now?

Nothing. If the UK were to allow the FCA Regs to fall away on repeal of the EC Act, counterparties to derivatives transactions under which collateral is provided by UK entities would no longer benefit from the protections afforded by FCD, but that seems unlikely.

Settlement Finality Directive

What does the SFD do?

The SFD gives certain protection to participants in settlement and clearing systems from the insolvency of other participants, and
the operator of the system. It preserves the effectiveness of any instruction for the transfer of collateral made prior to insolvency of the participant or system and provides that no national law on the setting aside of contracts entered prior to insolvency (e.g. the clawback provisions in the Insolvency Act 1986) is to apply to arrangements for the netting of amounts to be transferred in respect of transactions in the clearing system

Has the SFD been incorporated into the EEA Agreement?

Yes. The SFD is incorporated into the EEA agreement and is in force throughout the EEA.

Direct or indirect?

As a Directive, the FCD does not take direct effect in EEA Member States and was required to be implemented into UK law. This was done by means of the SF Regs. The SF Regs were also made directly under an enabling provision in the EC Act itself, rather than under FSMA. As a result, repeal of the EC Act at the date the UK leaves the EU will automatically repeal the SF Regs. Position for banks and investment firms using clearing systems if the UK is within the EEA As the SFD has been incorporated into the EEA Agreement, if the UK joins the EEA it will be required to implement legislation preserving the effect of the SF Regs when they fall away as a result of the repeal of the EC Act. Thus UK-based settlement systems will continue to operate under the SFD and the position in relation to protection from insolvency of participants and the clearing system should be preserved across the EEA Member States.

Position for banks and investment firms using clearing systems if the UK is a third country

Uncertain. The SFD provides settlement finality in the event of insolvency proceedings in third countries as well as in EEA Member States, so UK insolvency proceedings would still be within scope. However, the SFD would only take effect as between participants and clearing systems within the EEA Member States. Thus, in the event that the UK did not enact saving legislation preserving the SF Regs, users of UK-based clearing systems would need to evaluate the insolvency risk of participating in UK clearing systems under relevant UK law then in place.

What do firms need to do now?

Nothing. If the UK were to allow the SF Regs to fall away on repeal of the EC Act, participants in UK clearing systems would no longer benefit from the protections afforded by SFD, but that seems unlikely in practice.

Part VII of the Companies Act 1989

For completeness, note that the provisions of Part VII of the Companies Act 1989, which disapply certain provisions of UK insolvency law in order to protect (i) the rules of a clearing system on default of a participant and, (ii) related charges over collateral in respect of market contracts, are primary UK legislation and as such will be unaffected by the UK leaving the EU.

Glossary

• Additional EEA Member States means those EFTA countries which are party to the EEA Agreement, being Iceland, Liechtenstein
  and Norway.
• BCBS means the Basel Committee on Banking Supervision.
• BRRD means the Bank Recovery and Resolution Directive (Directive 2014/59/EU).
•  CIWUD means the Credit Institutions Winding Up Directive (Directive 2001/24/EC).
• CIWUR means the Credit Institutions Reorganisation and Winding Up Regulations 2004 (SI 2004/1045) (as amended).
• Companies Acts means (i) the Companies Act 2006 (note that the provisions relating to registration of charges created on or after 6 April 2013 are contained in sections 859A to 859Q, whilst the provisions relating to registration of charges created on or after 1 October 2009 and before 6 April 2013, now repealed, are contained in sections 860 to 877), and (ii) the Companies Act 1985 (the provisions relating to registration of charges created before 1 October 2009 are contained in sections 395 to 408).
• EBA means the European Banking Authority.
• EC Act means the European Communities Act 1972.
• ECB means the European Central Bank.
• EEA means the European Economic Area, which consists of the EU Member States and the Additional EEA Member States.
• EEA Agreement means the Agreement on the European Economic Area, which entered into force on 1 January 1994 and enables the Additional EEA Member States to participate in the EU’s internal market.
• EEA Member States means the contracting parties to the EEA Agreement, being the EU Member States and the Additional EEA Member States.
• EFTA countries means the four member states of the European Free Trade Association, being Iceland, Liechtenstein, Norway and Switzerland (Switzerland, however, is not a member of the EEA).
• EIOPA means the European Insurance and Occupational Pensions Authority.
• EMIR means the European Market Infrastructure Regulation (Regulation (EU) No 648/2012).
• ESAs means the Joint Committee of the European Supervisory Authorities, being the EBA, EIOPA and ESMA.
• ESMA means the European Securities and Markets Authority.
• EU Member States means those countries which are party to the treaties of the European Union and are, as a consequence of such, members of the EU.
• FCA Regs means the Financial Collateral Arrangements (No. 2) Regulations 2013 (SI 2003/3226).
• FCD means the Financial Collateral Directive (Directive 2002/47/EC).
• FCs or financial counterparties are, under EMIR, essentially, financial entities regulated in the EEA (or alternative investment funds managed by EEA-regulated managers in the EEA).
• FSB means the Financial Stability Board
• FSMA means the Financial Services and Markets Act 2000. Home member state means, under MiFID, as a general rule, the EEA Member State in which an investment firm’s registered office is located.
• Host member state means, under MiFID, the EEA Member State, other than the home member state, in which (i) an investment firm has a branch or performs services and/or activities, or (ii) a regulated market provides appropriate arrangements so as to facilitate access to trading on its system by remote members or participants established in that EEA Member State.
• IOSCO means the International Organization of Securities Commissions.
• MiFID means the Markets in Financial Instruments Directive (Directive 2004/39/EC).
• MiFID II means the Markets in Financial Instruments and Amending Directive 2002/92/EC and Directive 2011/61/EU (Directive 2014/65/EU).
• NFCs or non-financial counterparties are, under EMIR, EEA counterparties to OTC derivative transactions (other than central counterparties) that are not FCs.
• NFC+s are, under EMIR, NFCs which are part of a group in which the aggregate notional amount of outstanding derivatives, excluding hedging transactions, entered into by all NFCs within that group, exceeds the applicable “clearing threshold”.
• Resolution college means a college established in accordance with Article 88 of BRRD to carry out certain tasks as specified under Article 88(1) of that Directive.
• SFD means the Settlement Finality Directive (Directive 98/26/EC).
• SF Regs means the Financial Markets and Insolvency (Settlement Finality) Regulations 1999 (SI 1999/2979).
• Text with EEA relevance means a piece of EU legislation which has been identified as a “Text with EEA relevance” for incorporation into the EEA Agreement (note that the presence or absence of this wording does not definitively determine whether or not that piece of EU legislation should be incorporated into the  EEA Agreement).
• Third countries means those countries that are not EEA Member States.